AEY's Deceptive Accounting (Example)
Focus On Economic Reality, Not GAAP
Rules-based accounting can often be very deceiving (sometimes on purpose). Enron arguably followed all the rules. . . . with the sole intent to deceive. Recently, HYRF was a complete fraud in which a money-losing company reported .52 per share in audited earnings, arguably in full compliance with GAAP.
But clearly the intent of public auditors should be (and I believe FASB rules even require auditors) to give an accurate representation of the company's financial status. You can be following the "letter of the law" and be totally violating the "spirit of the law" and intending to deceive.
Let's take a hypothetical example and, focusing on economic reality (instead of accounting rules), work backwards to see why AEY's reporting is quite deceptive and earnings are overstated (on purpose).
Let's say you have a company with the following stats:
5 mil preferred shares
5 mil common shares
$10 mil in net income
$20 share price
Clearly the company has 10 million shares outstanding -- 5m preferred and 5m common. That's economic reality. The preferred have AT LEAST the same ownership rights and are AT LEAST as valuable as the common (unless the terms say otherwise), because they have priority, liquidation preference, etc. So the reality is we have 10 mil shares outstanding and the company is earning $10mil, or $1 per share. Stock price is $20, giving it a p/e of 20. Total market cap is $200m
Then let's say management decides to change things from 5mil preferred shares, to 500,000 preferred shares each with a "stated value" of $200 per share (which is also the amount required to pay them off).
Now if you just looked at the balance sheet quickly it looks like the "restructured" company only has 5,500,000 shares outstanding instead of 10 million shares, because of the "stated value" trick on the preferred. The company is still earning $10m, but now it's on 5.5 mil shares, so EPS appears to be around $1.82. This gives the $20 stock price a p/e of around 11, rather than 20 like it was before.
But has anything really changed? No. Before, the value of the preferred was $100m. After, the value of the preferred is still $100m (500,000 shares times $200 per share).
Further, lets just ignore economic reality and say that the company says the preferred cannot be converted into the common and therefore shouldn't be included in earnings. This gives the impression that the preferred shares just sort of disappeared (which they, of course, did not).
So now the very same company is earning $10m on 5m common shares outstanding, or EPS of $2 per share, for a p/e of 10.
This is extremely deceptive, because clearly the preferred accounts for half of the ownership in the company, and yet the company is attributing all the income to the common and none to the preferred. The preferred didn't go away just because management said it isn't convertible into the common. If for some stupid reason we want to keep the common and the preferred separate, then we have to separate the income as well. The economic reality is the preferred owns half the company. (If you had 1 single common share outstanding and 50 million preferred shares, would it be economic reality to attribute all the company's earnings to the 1 common share?)
So just by some accounting chicanery, we've cut our p/e in half. Permanently. If the auditors are willing to go along, we just increased the value of the equity. Permanently.
And we've deceived the public. Because nothing has really changed. The company now has a $100m market cap on the common equity ($20 share price time 5m shares outstanding), and a $100m liability hidden in owner's equity where no one is usually looking. Extremely deceptive. But enterprise value (and the true price you're paying) is still $200m ($100m market cap on the equity, plus $100m liability).
So how did we increase the value of the equity?
Lots of people look solely at the p/e to value things. Let's say the original p/e valuation (before we started playing games) was correct, and that companies in this industry tend to trade for a p/e of 20. At a p/e of 10, our stock appears seriously undervalued. It would likely trade at a p/e of 20 (just like it did when we started) not a p/e of 10. That means the stock would now be trading at a price of $40 (20 times the apparent $2 per share in "earnings").
So now the public is paying an enterprise value of $300m ($200m in equity, plus the $100m liability hidden in owner's equity) for a company that is only worth $200m. We sold the company for 50% more than it was worth. And more importantly, we got the public to pay twice what the equity was really worth ($200m instead of $100m), making our stock price go up 100%.
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This is essentially what AEY is doing. They're using a no-name auditor and my guess is that's the only way they're getting away with this.
The preferred stock exists. That's not debatable. The company says it exists. Further, the company states the value of the preferred (300,000 shares with stated value of $40 per share, or $12mil in stock). At the current stock price of $4 per share, the economic reality is the company has 3mil more shares outstanding than it is saying (roughly 30% more shares, and true EPS goes down accordingly).
It's ridiculous not to include the true value of the preferred in the fully diluted share count, because the preferred in this case (and nearly always) has AT LEAST the same features as the common as far as economic reality is concerned. Usually much better; after all, they are the higher-ranking shares. In AEY's case, the preferreds have no voting rights, but that's a mute point because two guys control the entire company (some incestuous deals too).
AEY's income statement records the cost of the dividend on the preferred shares, but ridiculously doesn't record the ownership portion of the shares themselves. Basically, the income statement says the company is paying a dividend on shares that don't exist.
So this is a case where GAAP rules can get an investor into trouble. I don't know for sure, but I'm guessing that there is no GAAP rule against excluding preferred shares from fully diluted shares. Why? Because I'm guessing the folks at GAAP probably never thought anyone would claim such a thing. They probably figured it was a given. I mean, after all, if you've got 5mil preferred outstanding and 5mil common outstanding, everybody knows there's 10m shares outstanding. A share is a share, right? The folks at GAAP probably never thought anyone would just claim the preferred doesn't exist.
That's why it's necessary that auditors focus more on "principles-based" accounting rather than "rules-based" accounting. There can't be a rule for every single thing.
In the board game Monopoly, for example, there is no rule stating that you can't take your hand and smack all the other guys' hotels off the board. Or that you can't urinate on the board and then claim that because you are "the car," the slick surface caused your vehicle to slide three more spaces, drifting right past the streets of Park Place and Boardwalk (and their accompanying high rents), and instead land directly on "GO," entitling you to an immediate $200 in cash, thank you very much!
Can't have a rule for everything. A certain amount of morals is just assumed. Unfortunately for all of us, that's often a poor assumption when it comes to the rascals running and auditing public companies.
P.S. Writing this late at night, so please excuse any typos, or errors in arithmetic or grammar.
